Gary Kleiman of Kleiman International -

Mongolia’s recent quasi-sovereign Trade and Development Bank five-year issue was given a lukewarm reception by frontier bond investors, in contrast to the enthusiasm for the country’s debut “Chingiss bond” in 2012. They checked the fine print for English law and cross-default clauses despite the 500-plus basis point yield pickup over US Treasuries, as all three credit rating agencies have Mongolia on watch for a potential downgrade, and reckless fiscal and monetary policies could again compel an International Monetary Fund (IMF) rescue.

Mongolia Prime Minister Saikhangligeg announced a breakthrough on the second funding and operating phase of the giant $5bn Oyu Tolgoi gold and copper mine during the bond’s roadshow, but actual production might not commence for years. New elections are scheduled for 2016 and political positioning could further delay urgent economic diversification and a clean-up of the banking system.

With the slowdown in China, which takes 90% of the country’s commodity exports, Mongolian GDP growth fell to 4.5% in the first quarter of this year. While the Anglo-Australian group Rio Tinto is the government’s main partner in Oyu Tolgoi, the smaller Tavan Tolgoi (TT) coal project has a Chinese-Japanese consortium.  Together the joint venture commitments equal the economy’s $10bn size. With over $1 trillion in estimated mineral wealth in a country with just 3mn people, double-digit foreign direct investment and a surge in output from the country’s mines fuelled an immediate boom after 2010 when an IMF post-crisis programme ended. But with the collapse in international inflows and raw material prices last year, officials have embarked on “unsustainable” domestic budget spending, according to the IMF’s March Article IV report.

Consumption accounted for almost all of 2014’s 8% GDP growth, as inflation was twice that figure on the combination of construction stimulus, interest rate cuts and exchange rate depreciation. Fiscal deficits continue to breach the 2% of GDP cap set out in a Stability Law, and public debt including state enterprise liabilities is put at 75% versus the statute’s 40%. The central bank has since reversed course and tightened policy, with the benchmark rate now well over 10% to throttle back last year’s 25% credit jump. The current account deficit is a whopping 15% of GDP, and despite a Chinese currency swap line foreign reserves have tumbled to a critical three months’ worth of imports and 75% of short-term debt. Bank balance sheets have doubled in the past two years and the 3% non-performing loan (NPL) ratio is widely believed to be under-reported with lax classification and stress-testing. Capital and liquidity vulnerabilities are “apparent” with real estate borrowers in trouble, the IMF believes.

Plus ca change

The prime minister and his team barely won a majority in the last elections and initially refused to confront the hard choices as foreign investor disputes resulted in lengthy detentions of foreign executives. Since then, his government has embarked on a national referendum by text messaging, which saw people vote to press on with stalled mining projects, and this year it modified the Fiscal Stability Law and prepared a “Comprehensive Macro Adjustment Plan.”

Amendments to the former will raise debt ceilings, and the latter sets out goals for business climate and structural reforms while encouraging import substitution, new services and technologies, and higher social spending. The macro plan does not correct public wage increases, untargeted subsidies and central bank mortgage support. After a 15% currency loss against the dollar the past year, intervention will be limited to episodes of “excess volatility” with the IMF citing inadequate reserves for defending a currency peg. By itself the $2bn in large external bonds maturing in 2015-17 could deplete the sum under a “high distress” risk scenario.

Pension and tax adjustments are long overdue, and social transfers at 8% of GDP go to all population segments even if not in poverty. A” mega-project” czar, a former prime minister, has been appointed to steer the Oyu Tolgoi and Tavan Tolgoi projects through the next negotiating rounds, but the move may be designed more to co-opt potential leadership rivals. The banking system, despite closures and restructurings in 2009, still lacks proper risk-weighted asset and bad loan provisioning norms. Foreign exchange loans were only recently flagged as a danger and the Tier I capital adequacy ratio should be hiked to 10%, experts recommend. Regulators need additional monitoring and resolution powers against “non-viable” banks the IMF advises as it looks toward a possible repeat bailout.

The Article IV survey characterizes the current crunch as liquidity not solvency-related, because the abundance of natural resources “could spell prosperity”. The authorities have proposed the creation of a sovereign wealth fund as earnings stabilize. However, as the cautious Trade and Development Bank bond subscription shows, global portfolio investors and commercial lenders, including the Chinese and Japanese aid agencies and Credit Suisse, may already be reluctant to increase their exposure to Mongolia right now. Official and private creditors face another transition with upcoming elections, and patience will wear thin as budget and financial sector priorities could further fade on the isolated landscape.